When Policy Credibility Changes the Transmission

Exchange-rate pass-through is shaped not only by how a currency moves, but by what firms and households believe that movement says about future prices. The BIS evidence makes this policy-state question concrete through inflation gaps, de facto exchange-rate arrangements, fiscal deficits, and public debt. This chapter examines how those variables are associated with the strength of pass-through, why an exchange-rate regime is not the same thing as realized volatility, and why the results support conditional policy vigilance rather than a simple ranking of fixed and floating systems.

Credibility, inflation gaps, and the meaning of a regime

An inflation gap is the distance between actual inflation and the central bank's target. It is not the same measure as average inflation: average inflation describes the general price environment, while the gap asks whether the current outcome is close to the promised policy objective. That distinction matters for expectations. A currency movement in an economy whose inflation is close to target may be interpreted as a contained adjustment. The same movement when inflation is far above target may be read as evidence that costs and prices are becoming less anchored.

The BIS study examines this relationship within the smaller group of country-decade observations that have an inflation-targeting framework. Only 22 percent of the country-decade observations belong to inflation targeters, and the median inflation gap in that subsample is 0.7 percentage points. Those details are not incidental. They tell us that the result is not a universal estimate over all countries, and that most observations lie near the target. The evidence is strongest for distinguishing ordinary, small deviations from unusually large ones within that selected policy environment.

Within the inflation-targeting subsample, the fitted one-year pass-through remains around 20 percent when inflation is below target or the positive gap is small. It rises sharply once the gap exceeds roughly 2–3 percentage points. The pattern is consistent with a credibility mechanism. When the central bank is broadly meeting its objective, firms may expect a currency movement to have limited consequences for the general inflation process. When the gap is large, the movement can be incorporated into a wider story of persistent cost pressure, and price setters may be less willing to wait.

This does not mean that a central bank can lower pass-through by announcing a target. Credibility is not a label; it is an outcome that depends on whether private actors believe the policy framework will stabilize prices over time. Nor does the estimate prove that a larger inflation gap causes firms to pass through a particular fraction of a currency movement. Inflation gaps can reflect supply shocks, fiscal conditions, demand pressure, or errors in expectations. The BIS result identifies a non-linear association that is relevant to how a policy environment may be read, not a mechanical policy lever.

The exchange-rate regime adds another dimension. The BIS uses a de facto classification, meaning the arrangement reflected in observed behavior rather than only the formal policy description.